Mid, Small-Cap Selloff Does Not Deter This Fund Manager

Rajesh Bhatia: So basically, you know, we've been kind of maintaining all along since the bottom in March 2023 that we like the quality of the rise of this market, because the breadth of sectors that have been participating in the markets would suggest to us that this is a bull market.

You should notice that a lot of economically sensitive sectors have been participating on the rise. And you should also know that markets are usually a leading indicator of the economy as well and that's why, it kind of tells you that this is a startup in the economic cycle. And it's only been a few years and you can see that in various things, especially on the capital expenditure side, but you can see that a lot of what has started is a five-year, seven-year story. I think, you know, as far as the power sector is concerned, there is $500 billion of investments—like half a trillion dollars of investments—to come in the next 5-7-10 years as far as the semiconductor ecosystem that has been created, as far as roads, railways, real estate, that kind of capex that is happening. A lot of that capital expenditure cycle is really at the start of the economic cycle and I think the market seems to be kind of suggesting that as well.

So as an investor, of course, I think there's a lot of debate on whether the valuations are expensive or not, and what should you do about that. As an investor, I worry if I was in the late stage of a valuation cycle and a late stage of an economic cycle. What do I mean by that?

You know, between 2003 and 2007, we had an economic cycle, which was really long. In the last three years of that economic cycle, the GDP grew at 9%. That was a really overheated economy, and then the valuation cycle also kind of extended itself. What was 15 times earnings average for the last five years—between 2003 and 2007—became 23 times. So you became at the late stage of the valuation cycle as well. What was the result of that? Markets corrected 50-55%, which was the worst year in 30 years for the Indian stock markets. Fortunately, maybe, we are perhaps at an early stage of an economic cycle, even though I think there is some valuation debate whether we are overextended on the valuation side.

I think the correction that we are seeing right now is probably healthy. I think we're still in a bull market. But bull market corrections can be violent. I think there was excessive enthusiasm in the mid caps and small caps. So the fact that they are correcting is a very, very healthy phase of the market and a very necessary one in a bull market as well. So that's really what I think is going on at this moment.

Rajesh Bhatia: Basically, we are an institution. And of course, we have all of these funds as well. We are fairly excited about the mid-cap and the small-cap space, as far as the medium to long term is concerned. You know, the last time I spoke to you, I said, while there is value in the mega caps, the India story is in the mid caps and the small caps.

I think over a longer period we are finding far many faster growing opportunities, which leverage the India growth opportunity in the mid-cap and small-cap space than we are finding in the mega caps. So over the medium term, we are excited but you know how the mid-cap and small-cap stocks behave.

In a bull market, the marginal buyer decides the price and in a bear market, the marginal seller decides the price, because these are illiquid relative to the mega caps. So of course the volatility that is associated with mid caps and small caps is higher. So, given that context, we would feel that over a medium term, I think it's still good to be in the mid-cap and small-cap space. There is an excessive enthusiasm. You have to be selective. This is the time to improve the quality of your portfolio because in a bull market, what tends to happen is while good stocks go up, bad stocks go up as well. So fortunately you've been given an opportunity to improve the quality of your portfolio as you move forward. But over the medium term, we continue to be bullish on the mid-cap and small-cap space.

Rajesh Bhatia: So, I mean, you have to look at it from various perspectives. So let's say, if there is a high-beta sector that has done exceedingly well and the valuations don't seem comforting to you anymore. You should exit those opportunities. There are stocks in the public sector category, which have undeservedly gone up to an excessive amount. So we don't own it, but there is an NBFC in the PSU space, which quotes at four times the price-to-book. So of course, you need to exit that.

We have to also remember that in this bull market, we have benefited enormously from cost of goods coming down. So, gross margins of companies have benefited enormously. Now as you move forward, the earnings growth has to be driven by the top line, because you already got your margin expansion. Let's say, if that was the case for a two-wheeler business, or a tyre business, which benefited enormously from cost of goods sold coming down and therefore margins have expanded. But you don't have a view that the top line is going to accelerate in a very strong way. But yet the valuations have kind of gone up significantly. You should take those profits. I hope I made the point of what you should be kind of getting out of.

What should you move into? You should move into stronger business models—ones, where you don't doubt the execution capability. So, strong business modes, less cyclical and steadier growth prospects, where the valuations still appear healthy to you. Let’s say like a general insurance company. So that's really what we have done as well. We have improved the quality of the portfolio. So, in effect, we have reduced the beta for our portfolio.